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September 30, 2009

New Bull Market or Trojan Horse?

Aside from how investors feel about stocks and the economy, there are additional data points which offer a strong clue about the market's future.

You've probably heard that a new bull market has to climb the proverbial wall of worry. Quite frankly, investors do not seem worried, so if your gut feeling is telling you that stocks around current levels are simply too good to be true, you are probably right.

Aside from how investors feel about stocks and the economy, there are additional data points which offer a strong clue about the market's future.

1) Long-term weakness. The United States has slowly deteriorated from a manufacturing powerhouse with real profits to a nation dependent on artificially engineering profits and trade surpluses. The nation's Gross Domestic Product (GDP) has been steadily declining for many decades. The average annual GDP for the 25-year period starting in 1975 is nearly 1 percent lower than from 1942 - 1966.

The average annual GDP from 2001 - 2008 is 2.23 percent lower than the normal levels seen from 1942 - 1966. Real GDP for the first quarter of 2009 decreased by 6.4 percent. The majority of the last three decades' corporate profits have been derived from easy credit and financial maneuvers that take advantage of this excess liquidity.

2) Current weakness. The Baltic Dry Index (BDI), an index that measures shipping costs for giant sea freighters, has dropped from nearly 12,000 to below 2,500. As the stock market has rallied over the past six months, the BDI has continued to decline. This is worrisome as shipping activity is a direct reflection of demand. If the economy was truly recovering, demand would be increasing.

3) Stocks are still over-valued. The S&P 500 is trading north of a 26x P/E multiple based on trailing operating earnings. Historically, those valuation levels foreshadow a decline in the coming year 60 percent of the time. The P/E multiple on non-scrubbed reported earnings has actually soared to 184x. This is an all-time high and even dwarfs the P/E ratios seen during the dot.com bubble by a large margin.

Historically, bear market bottoms have only been reached when valuations (as measured by P/E ratios and dividend yields) were reset to what the market (not investors) deems fair. Just like the human body isn't healthy unless it runs at 98.6 degrees, the stock market is not ready for a recovery unless those valuations have been reset.

The 2002 market bottom did not last because valuations did not reach the levels required for a major bottom. From current levels, the market will have to drop quite a bit to reach historic levels indicative of a market bottom.

The ETF Profit Strategy Newsletter contains a detailed analysis of P/E ratios; dividend yields mutual fund cash levels and investor sentiment which provides a target level for the ultimate market bottom. Once this bottom is reached, the wall of worry will be all too obvious.